Investment Perspectives - October, 2001

September, 2001, won't soon be forgotten. Investment-wise, it belongs in the same league as October, 1987, and September, 1929. It wasn't a single day crash in the traditional sense, but stock markets around the world suffered unusually heavy losses for the month.

The problem wasn't just the terrorist tragedies of September 11th (911 for short), but also the increasingly recessionary environment in the aftermath of the internet/investment/consumption bubble of the late 1990's. The bubble developed because of dramatic growth in internet traffic (it doubled every 100 days) and irrational fear of Y2K. Y2K stimulated significant expenditures to upgrade corporate computer systems and processes in 1999, but left an investment void in 2000. And the dramatic growth in internet traffic generated lots of spending on networks and equipment, but it failed to translate into profits for the dot.com companies. On top of all this, consumers spent a larger share of their income than normal in the late 1990s, needing to allocate less money to their retirement accounts because the rising stock market was benefiting these accounts immensely.

So where are we now? Concerning the economy, it doesn't look good at all. Even before "911", capital spending was falling, layoffs were rising and consumer spending was sluggish at best. Since "911", consumers have tightened their belts, travelers have cut back significantly and businessmen are sitting on their hands, deferring all expenditures possible. In short, as the U.S. and most of the rest of the world was sinking slowly toward a recession, "911" shattered the confidence of consumers and businessmen alike and provided the final jolt.

The Federal Reserve Board and the government have not been idle. Sharply reduced interest rates, tax rebates and lower tax rates have been put in place and will eventually help stimulate the economy. But they haven't yet, and it is proving very difficult to coax businessmen to invest when they already have too much capacity, and to induce consumers to spend when they are nervous and uncertain about their jobs, their incomes, and their investments.

I don't think the immediate effects of "911" will be long lasting. Like a rubber ball that is dropped, the bounce should be fairly strong, though it will not recover fully to the point from which the ball was dropped. Some travelers will never fly again, for instance. But, barring another terrorist strike, "911" will soon become a distant memory and most people will return to their normal level of flying and buying.

The longer term economic outlook is not as bright. Business capital spending grows at a long term annual rate of approximately 10%. In the late 1990s, capital spending growth accelerated to as much as 20% per year. My guess is that we are now in the process of reverting to the mean, resulting in a period of sub 10% growth in capital spending that could last 5 years or so. On the consumer side, the percentage of income allocated to savings fell from about 8% in the early 1990s to zero by 2000. Since the bull market of the '90s has now ended, people will undoubtedly begin to save more of their income and spend less. So, I expect that consumer spending growth will also be subnormal for the next few years.

Given an economy currently in recession, followed by a period of subnormal growth, one might expect the stock market to continue its decline. But I don't think it will. I actually think we are near the bottom. The market peaked in March, 2000, and has been declining for 18 months. The longest bear market in recent memory was 18 months in 1973-74. Not surprisingly, the recession in 1973-74 also lasted about 18 months. Historically, the stock market peaks about 6 months before the onset of a recession and bottoms about 6 months before recovery begins. That was true in 1973-74 and should be true this time. Though aggregate economic statistics show that the economy exhibited growth through the 2nd quarter of this year, industrial production actually began to decline in August, 2000, and the technology sector slumped noticeably in November, 2000. I am thus choosing to date the start of this period of economic weakness to the autumn of 2000. If this period of economic weakness were to extend for 18 months, it would end in the spring of 2002. If the economic recovery were to start then, one should expect the stock market to begin its recovery 6 months earlier, or about now. This is a rather long way of saying that I expect the economy to hit bottom next spring, and the stock market to bottom about now, 6 months sooner.

Another reason I think we may be near the bottom is that bear markets typically progress in phases, with modest declines initially and severe declines near the end. Last month's decline certainly qualifies as severe.

Most of us have seen our portfolios shrink substantially this year, and the experience is not pleasant. If it's any consolation, the average growth oriented mutual fund investor has lost between 25% and 30% so far this year on top of a 10-15% decline last year.

In conclusion, I think it is likely that the worst is over for the stock market, even though the economy will remain in recession. I doubt if the market will be off to the races any time soon, but, if we can succeed in identifying companies that can grow in spite of a sluggish economy, we should eventually be rewarded.

Jeffrey L. Friedberg